A Q&A With NEOS: Income, Tax Efficiency, and More | ETF Trends

In the sea of 427 new ETFs launched last year, it can be easy to miss some of the more quietly innovative funds that outperform. The NEOS lineup of income-focused ETFs spanning equities, bonds, and cash alternatives are three funds that launched towards the end of the year and are ones not to be missed, aiming to provide high monthly income, tax efficiency, and strong risk-adjusted returns.

VettaFi recently had the chance to sit down with Troy Cates and Garrett Paolella, both co-founders and managing partners of NEOS, to talk about their firm, ETF solutions, and what sets their funds apart from others.

Karrie Gordon, staff writer at VettaFi: So, first things first, I know NEOS as a firm is newer to the asset manager stage, but both of you have been involved in the industry for quite a while now. Can you give me a bit of your background and why you decided to come together to form NEOS?

Garrett Paolella, co-founder and managing partner at NEOS

Garrett Paolella, co-founder and managing partner at NEOS: Troy and I have worked together for almost 15 years. We originally created a firm called Recon Capital that launched one of the first option-based ETFs [now the Global X NASDAQ 100 Covered Call ETF (QYLD)]. Troy and I worked together on the institutional sell side, covering hedge funds and mutual fund companies, where we focused on building out the listed options desk for the firm we worked for.

Throughout my entire career, I’ve focused on building strategies that aim to generate income, manage risk, or blend both. At NEOS, we wanted to build on what we started back in 2013 by being a solutions provider to financial advisors and investors. Our product suite offers them a variety of solutions to mitigate risk and enhance income on top of their core portfolio.

Troy Cates, co-founder and managing partner at NEOS: I spent the first ten years of my career on the market-making and trading side of equities and options. Eventually, I met Garrett on the institutional side and then moved to asset management. Over the years, I’ve developed a diverse background on the trading and portfolio management side, which has been a nice career trajectory.

NEOS Brings Added Benefits to Core Allocations

Gordon: Ok, so talk to me about your ETFs. You’ve got three that you launched last August that are all options-based and income-seeking. What are you doing differently within equities?

Paolella: We’ve evolved the product offerings from tracking passive covered-call (also known as buy-write) indices to utilizing a quantitative, data-driven approach behind our covered call strategy on the S&P 500. The way that materially differs from many of the products in the marketplace is through a laddered short call: we have multiple short calls, which allow us to get more upside, generally, than just being in one specific position. We’re able to buy a spread, and then we can take a portion of that short call and that option premium and buy a long call to help protect the upside, but we don’t have to write on the entire portfolio.

Troy Cates, co-founder and managing partner at NEOS

Cates: When we were looking at what products were out there, a lot of them are legacy products — they’ve passively managed funds that have been out for a long time and that people are comfortable with. What we were looking to do with our products is to offer ETF solutions that could fit into anybody’s core allocation. The NEOS S&P 500 High Income ETF (SPYI) has income generated off the S&P 500 but can still participate in a lot of the upside. A lot of people we talked to in the marketplace wanted to have the potential for upside capture while also aiming to generate high monthly income through our options strategy.

Gordon: You’ve taken a step further and done something that I find interesting and seems to be a big hit with advisors. You’ve taken this strategy and implemented something similar in both bonds and cash alternatives. Tell me a bit about those funds and how they work.

Paolella: The core thesis is that we wanted to continue to evolve the market and offer solutions, which is why we’re also offering ETFs providing core fixed income exposure and a cash alternative. Looking at our entire suite, there are ways to generate yield enhancements without equity inclusion in fixed income. We look to add 2-3% of tax-efficient income above core bonds, and we look to generate 1-2% above 90-day Treasuries in our cash alternative product.

Cates: For the core bond ETF, NEOS Enhanced Income Aggregate Bond ETF (BNDI), we wanted to create a product that allows investors to generate meaningful income and total returns from their core bond portfolio regardless of what happens in the market, especially in a rough year like 2022. We do that by implementing an option overlay that aims to add 200-300 basis points per year which is distributed back to investors on top of what they’re getting from their ordinary core bond exposure.

For the cash product, the NEOS Enhanced Income Cash Alternative ETF (CSHI), the most interesting part when we were building it was that Treasuries weren’t yielding anything; we were just looking to give 1-2% a year, pay it monthly and offer a cash alternative that had similar volatility to the underlying asset. When we launched it at the end of August, Treasuries had moved up to 2-2.25%, and we were excited because now this product has a really heavy yield.

We were just buying some 90-day T-bills this morning, and we’re getting 4-4.5% on those now, so our product is yielding 5.5% plus. It’s become a really attractive yield product while still having low volatility and basically sitting in cash.

It’s All About Options

Gordon: This sounds like a really novel approach within ETFs. What is it about this particular kind of options strategy that’s appealing, and what types of options are you using and why?

Paolella: Institutional investors manage money this way: they’ll do cash-secured put writing against their fixed income exposure in some way, shape, or form. We think of this not only as a solution for retail investors but also for sophisticated financial professionals and institutional investors because these are time-tested strategies, just like covered calls.

We’ve built the portfolios to focus on the underlying investment, the core investment. For the cash and Treasuries, we’re in options that are meant to be extremely conservative with a volatility and risk profile that’s much more like an ultra-short duration bond. For BNDI, core bonds have had an average of 3.5-4 standard deviations if you look back over the full markets in the last 15 years. We want the underlying options to have that same risk profile and generate 2-3% in yield enhancement while also being tax-efficient income above what you’re getting.

Cates: We use index options that come with tax advantages under rule 1256, where your distributions are taxed at 60% long-term and 40% short-term, but there’s also way more liquidity in these kinds of options. This is more like an institutional strategy because institutions trade in index options; they’re not looking at underlying ETF options. We’re specifically trading SPX index options with the most liquidity on the options market.

It really comes down to tax efficiency, liquidity, and access to different strikes because we’re rolling the two fixed income portfolios on a weekly basis and trying to move with the market. Everything is systematic and rules-based, and everything we trade, whether it’s weekly for the fixed income funds or monthly for the equity side, is being reviewed by the three portfolio managers to see what our models are indicating before making the trades.

Gordon: This has been really great. Are there any last things that you think advisors should know about your ETFs?

Paolella: We’ve held hundreds of meetings so far, and it always comes down to tax-efficient monthly income. We are basically asset class agnostic; we just want to create your core positions that are your foundational building blocks but do that with an added layer of tax-efficient monthly income generation and risk mitigation.

For more news, information, and analysis, visit the Tax Efficient Income Channel.